British Pound Could Stage "Surprise Recovery" as Pessimistic Markets are Forced to Row Back

- Surprise reversal for under-fire Sterling could be on the cards say Forex.com

- BMO Capital forecast Sterling to remain supported over three- to twelve-month period

- Brexit customs agreement, inflation data seen as potential catalysts for recovery

- Pound-to-Euro exchange rate @ 1.1395 today, Pound-to-Dollar exchange rate @ 1.3422

© Goroden Kkoff, Adobe Stock

May has turned into something of a nightmare for those holding out for a stronger Pound - the UK currency is down 3.64% against the Dollar over the course of the past trading month alone, while it is a shade lower against another laggard of the global FX space; the Euro.

A combination of a resurgent U.S. Dollar, below-expectation economic data and concerns over an apparent stalemate in Brexit negotiations are seen to be behind the underperformance in the British currency. Tuesday, May 22 sees negotiators enter another round of negotiations in Brussels which suggests headline risks surrounding the progress of talks could well become a feature of coming days.

"Sterling’s downbeat start to the new week suggests market participants are not too optimistic about the prospects of a breakthrough in Brexit talks ahead of the next round of negotiations with Brussels on Tuesday," says Fawad Razaqzada, an analyst with brokers Forex.com who notes recent efforts to solve the Irish border dilemma have yielded frustration as solutions put forward by the U.K. appears unacceptable to the E.U.

The Irish border is however at its heart a question of customs arrangements, and here the U.K. side of the table is not united with various factions advocating a different degree of autonomy from the existing European Union customs union.

Nevertheless, markets have for much of 2018 opted to ignore Brexit, assuming that both sides will pull through with an agreement in the end.

Sterling has therefore been able to look to other drivers, for instance the economy, for direction. Yet recent price action suggests Sterling appears to once again be focussing on the Brexit issue now that we are approaching another soft deadline in the form of the June 28-29 European Council meeting, when signs of notable progress are supposed to have been made.

But, here too lies opportunity for Sterling.

Forex.com's Razaqzada says "this extremely negative sentiment towards the Pound makes us wonder whether the currency will stage a surprise reversal." Razaqzada believes there is always a chance that an agreement could be reached, especially if the U.K. agrees to remain in the customs union after its full departure from the EU in 2021.

A report carried by the Daily Telegraph suggests that the U.K. is prepared to remain in the customs union for longer than the already negotiated two year transitional period in order to avoid having a hard land border with Ireland.

While this has been met with dissatisfaction from politicians eager to make a clean break from Europe, from a market perspective this outcome "would most certainly be a positive outcome for the Pound," says Razaqzada.

Stephen Gallo, a foreign exchange strategist with BMO Capital says he expects "a final decision on the Irish border issue to be extended well into the Brexit transition period. Given the lack of consensus within the government, a time-limited customs/EEA-style compromise with the E.U. is probably the most likely direction for the U.K."

Gallo believes markets are too pessimistic at this juncture regarding the Sterling outlook, and he believes there is some upside to be had against both the Euro and U.S. Dollar.

"Brexit negotiations during the summer are likely to represent a source of volatility for the currency, although some breakthrough might emerge at the upcoming European
Council meeting on 28-29 June. Indeed, press reports suggesting that Britain will tell the E.U. that it is prepared to stay tied to the customs union in a “backstop plan” beyond 2021 are encouraging," says Roberto Mialich, an FX Strategist with UniCredit Bank in Milan.

UniCredit believe such an outcome would help reduce the “Brexit risk premium” on EUR/GBP, i.e. the difference between the actual exchange rate and where traditional fundamental drivers suggest it should be.

In short, should Brexit-induced risk fall away, then the only way is higher for Sterling.

Advertisement
Get up to 5% more foreign exchange by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here.

Near-Term, Watch Inflation

However, our suspicion is that those looking for a Brexit-inspired recovery in the Pound might be left waiting as this could be a slow-burning story; we note markets are less reactive to Brexit headlines in 2018 than they were in 2017 as traders opt to wait for concrete details as opposed to rumours.

Near-term we would not expect any major surprises on the Brexit front, and it falls to economic data to 'provide the goods'.

The key event risk for Sterling this week is the publication of the latest inflation figures from the ONS on Wednesday, the outcome of which will influence expectations as to when the Bank of England will next raise interest rates. The rule-of-thumb being that these expectations will be brought forward should inflation beat expectations, which will in turn likely support Sterling.

Headline Consumer Price Index (CPI) is expected to have remained unchanged in April at 2.5% year-over-year, while core CPI is seen easing down to 2.2% from 2.3%.

Razaqzada says any positive developments in Brexit negotiations and/or a positive surprise in inflation data could lead to a rebound in the Pound.

"We sense an opportunity to buy the GBP brewing on the basis that domestic inflation pressure is building and is likely to bring BoE rate hikes back on the agenda, and home-grown political risk may fade," says Greg Gibbs, Founder and Analyst with Amplifying Global FX Capital.

BMO Capital's Gallo agrees, saying there is the chance foreign exchange markets are too bearish on Sterling as U.K. economic data prints should soon improve.

"We expect forthcoming data to show more underlying strength in the UK economy than what was captured by the first estimate of Q1 GDP," says Gallo in a briefing to clients. "Mark Carney made it clear in May that the central bank is on a gradual tightening path. Given the upward trend in wages, the implied odds of a Bank of England rate hike in the June-September window are probably too low; we expect a 25bp hike in August."

Forecasts for the Pound

BMO Capital believe the labour market in particular presents the U.K. with a strong hand,  and they forecast the Pound to move higher as markets come around to their view.

The UK economy went through what is likely to be exiting a temporary ‘soft patch’ the saw it grow by only 0.1% in the first three months of 2018 as a result of the unusually cold weather. But, an antidote to the weak growth numbers were last week’s labour market figures which showed employment rising by 197k in Q1, the strongest for three years.

As such, BMO Capital forecast GBP/USD to rebound to 1.38 in three months and 1.53 in twelve months and for the BoE to deliver the next rate hike of the cycle in August.

The EUR/GBP exchange rate is forecast at 0.87 in three months and 0.85 in twelve months; this gives a Pound-to-Euro exchange rate at 1.15 and 1.1760 respectively.

Keep an Eye on Yields

Those watching Sterling near-term must also remember that global bond yields are playing an important role in guiding global currencies at present; and this is seen driving the U.S. Dollar higher, making a recovery in GBP/USD appear quite remote to us at this point.

But, the dynamic is proving moderately supportive for Sterling-Euro we believe.

Pound Sterling last week registered a monthly high against the Euro at 1.1472, having advanced for four days in succession as foreign exchange traders continue to take their cue from developments in the gargantuan global bond markets.

The current market dynamic appears to be favouring the currencies of countries that command a higher yield on their sovereign debt; the strengthening Dollar appears to be the big theme for foreign exchange markets once more with a jump higher in the yield on US Government bonds being the key culprit behind the advance.

At the time of writing the US ten-year yield is at 3.06%, UK ten-year yields are yielding at 1.5%, and the German bund 10-year yield at 0.62.

If we attach the relevant currencies to the yields, we get a similar order of performance: the Dollar is dominant, while the Pound is outperforming the Euro.

Advertisement
Get up to 5% more foreign exchange by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here.